Sector dispersion is the variation of returns between sector indices over time. It is a quick measure of industry level dislocations. Mathematically, it’s cross sectional variance of sector returns. A look back of around 10 to 40 trading days is typically used for calculating sector dispersion.
Indicators like index returns, implied volatility, stock dispersion etc have been widely used to classify market into different regimes. Use of sector dispersion as a regime indicator is largely unheard of. Sector dispersion measures the industry level deviations and can be high even in tranquil markets. Large values primarily indicate a fundamental shift in the outlook of market participants. It is a subtle yet powerful indicator of changing market dynamics.
Effect on strategy performance:
Sector ignorant trading strategies are stock trading strategies which do not take sector level information into account while generating trading signals. Jegadeesh and Titman’s medium term momentum strategy will fall into this category. These strategies unknowingly end up with large sectorial exposures when sector dispersion is high. On days following the high sector dispersion times, they can show very erratic returns. This is because the unmodeled sector level dynamics would play a significant role in determining the future stock returns. Hence sector dispersion can be used to dynamically alter the exposure of such strategies.
Sector dispersion is also a good predictor of future market volatility. High sector dispersion typically precedes high market volatility.